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Addicted to Dove

As widely anticipated, the US FOMC left policy unchanged at 5.5% at the September meeting. However, the dot plot was marked up again by more than expected, reflecting the hawkish stance of the Fed. The oxymoron description shifted from “dovish hike” to a “hawkish pause” reinforcing the prevailing bias of “higher-for-longer” comparted to market expectations for meaningful cuts in 2024. Of course, the Fed have never had a good track-record of forecasting beyond a few months. The same institution said “no tech bubble” in 2000, “subprime contained” in 2007, “green shoots” in 2009, “funds rate through neutral” in 2018, “transitory” in 2021 and now “higher for longer” in 2023. Historically it has paid to fade the Fed at major inflection points.

As we have noted recently, the irony of the consensus belief in soft landing and higher-for-longer (rates) is that it has become the prevailing bias just at the point where macro conditions have started to roll over. The US economy has been remarkably resilient this year. It is likely a function of; 1) accumulated excess savings since 2020; 2) Fed liquidity support during the regional banking crisis; and 3) the extraordinary fiscal thrust in the first half of the year. However, the forward-looking point is that all three factors have now flipped from positive to negative for the economy and markets. A related point is that it just takes time for the transmission mechanism of policy tightening to work.

Resilience in underlying macro conditions was most evident in the labour market in the first half of the year. The US unemployment rate was 3.4% in January and April or the lowest since 1969. However, the leading indicators of labour market conditions have started to deteriorate over the past few months. Temporary hiring has slowed, jobless claims have started to trend higher, and the unemployment rate is up 0.4% from the trough. US non-farm payrolls have also been revised lower for seven consecutive months. Total job openings have also plunged over the past few months. That is a leading indicator of the labour market, the cycle, Fed Funds rate and implied equity volatility (chart 1).

It is ironic that the Fed has upgraded its trajectory for growth given the key challenges likely to be facing the economy in Q4 this year, including the potential impact of auto strikes, another government shutdown, and the resumption of student loan payments. Moreover, factors that supported the economy and markets in the first half of the year such as the Fed balance sheet (emergency liquidity – chart 2), fiscal easing and excess savings are likely to reverse.

As we have noted recently, 2023 has been the year of the contras where swings in major macro trends have caught consensus positioning and beliefs offside. From a behavioural perspective it is important to remember that price itself can drive fundamentals by affecting perceptions of risk and the required rate of return. Or put another way price action can drive narratives or the prevailing bias. Narratives or as we describe it – consensus beliefs – will often skew positioning and lead to opportunities for contrarian investors.

On that note, flows and consensus beliefs as measured by the Bank of America fund manager survey highlight the overwhelming preference for US tech and the underweight to energy. That consensus positioning would caught be meaningfully offside if oil continued to rally toward, say $120, and/or Treasury yields (discount rates) continued to rise. The preference for technology stocks and the way price responds to hawkish news flow reinforces our sense that investors remain addicted to a dovish Fed. Of course, if the Fed is forced to capitulate on higher-for-longer and eventually cut rates, that is likely to be in response to a non-trivial deterioration in growth and profits. Put another way, a rate cutting cycle in response to a genuine growth scare is not bullish for equities.

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